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Why two economists’ work in contract theory won them a Nobel Prize

Contracts permeate our lives: just think of the contract with your employer or your insurance provider or your bank to get a loan — even your marriage is a contract. But why are they designed the way they are?

Economists Oliver Hart and Bengt Holmström developed a framework that allows us to understand and design better contracts. On Monday, the two U.S.-based economists were awarded a Nobel Prize in economic sciences for their contributions in contract theory.

Key to contract theory is incentive. For example, a contract must incentivize employees to work in the interest of their employer via payment and other forms of compensation.

Holmström’s contributions focused on the need to balance this incentive with risk. And since an employer is often able to shoulder this risk better than an employee, contract theory suggests that risk should be shared.

As the Nobel committee explained, “In industries with high risk, payment should thus be relatively more biased towards a fixed salary” — to offer employees stability — “while in more stable environments it should be more biased towards a performance measure” — to give employees incentive to work harder and not become complacent.

This balance between risk and incentives also applies to insurance contracts.

“We would love if the insurance company fully covered our losses if we had an accident or if our houses burned down,” said Per Strömberg on the Nobel Committee. But “if we know that we are fully covered” — that is, that we have no risk — “we are not going to take as well care of our property as we otherwise would have.”

Enter deductibles and copays. These tools, some say, provide us incentives for taking care of our homes and our health.

Economist Oliver Hart studied a different aspect of contracts: the reality that most of them are incomplete. What does that mean?

Since no one can predict the future, no contract can anticipate future circumstances. Thus, a contract “must specify who has the right to decide what to do when the parties cannot agree,” explained the Nobel committee.

Another aspect of Hart’s work on incomplete contracts examined whether certain services are better provided by the government or by a private company.

Should prisons be privately run? Should schools be public? Are hospitals better off when run by the government or when they are run privately?

At issue, Hart concluded, is whether quality or cost-reduction is more important.

When cost reductions compromise quality, public ownership may be better. But government ownership offers weak incentives for both cost and quality innovations.

In a 1997 paper, Hart and his co-authors discussed the issue with a focus on private prisons. The incentive to reduce costs too often hurts the quality of the facility, the paper found. This has been a topic in the news lately. The Justice Department recently decided to phase out its use of private prisons citing inferior conditions in privately run prisons.

“To conclude, this theory has really been incredibly important not for just economics, but for other social sciences, so everything from corporate governance and firms to constitutional law and politics can be analyzed with these kind of tools,” said Strömberg in his closing remarks. “And thanks to their research we know can analyze not just financial terms — who should get paid what — but control and decision rights — ownership, property rights.”

Interested in learning more about Hart and Holmström’s work? Here are a few economic papers by the two laureates:

  • “Pay Without Performance and the Managerial Power Hypothesis: A Comment” by Bengt R. Holmström: “A need for corporate restructuring, which emerged already in the 1970s, led to the remarkable rise in shareholder influence and the relentless pursuit for shareholder value. It placed exceptional demands on boards and led to extreme pay schemes that appear to have served the restructuring purposes well, but had unintended and unfortunate side-effects. In contemplating pay and governance reforms, it is essential to keep in mind the longer chain of events to avoid naive corrective measures that do not take into account the information and incentive constraints under which the various constituents and bodies in the larger governance system, especially the boards and shareholders, operate. Some of the recent advice on executive compensation seems very misguided in a longer historical perspective as is the push for extensive shareholder intervention rights.”
  • “Managerial Incentive Problems: A Dynamic Perspective” by Bengt R. Holmström: “The paper studies how a person’s concern for a future career may influence his or her incentives to put in effort or make decisions on the job. In the model, the person’s productive abilities are revealed over time through observations of performance. There are no explicit output contingent contracts, but since the wage in each period is based on expected output and expected output depends on assessed ability, an ‘implicit contract’ links today’s performance to future wages. An incentive problem arises from the person’s ability and desire to influence the learning process, and therefore the wage process, by taking unobserved actions that affect today’s performance. The fundamental incongruity in preferences is between the individual’s concern for human capital returns and the firm’s concern for financial returns. The two need to be only weakly related. It is shown that career motives can be beneficial as well as detrimental, depending on how well the two kinds of capital returns are aligned.”
  • “More is Less: Why Parties May Deliberately Write Incomplete Contracts” by Maija Halonen-Akatwijuka and Oliver Hart: “Why are contracts incomplete? Transaction costs and bounded rationality cannot be a total explanation since states of the world are often describable, foreseeable, and yet are not mentioned in a contract… We offer an explanation based on ‘contracts as reference points’.”
  • “Continuing Contracts” by Maija Halonen‐Akatwijuka and Oliver Hart: “Parties often regulate their relationships through ‘continuing’ contracts that are neither long‐term nor short‐term but usually roll over: a leading example is a standard employment contract. We argue that what distinguishes a continuing contract from a short‐term (or fixed‐term) contract is that parties apply notions of fairness, fair dealing, and good faith as they revise the terms of the contract: specifically, they use the previous contract as a reference point.”

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